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The How and the When of Tax Loss Harvesting

Discussion in 'Investments and Savings' started by Matt, Sep 14, 2014.

  1. Matt

    Matt Administrator Staff Member

    I've been working on a method to 'safely' Tax Loss Harvest (TLH) which brings together many recent thoughts. However, in doing so, I realized that perhaps TLH is another one of those things being overplayed, again by the Robo Advisor crowd. I've not yet conducted deep research on this, so would certainly be glad to be proven wrong here.

    I suppose I should start with 'The What?' before The How and The When. Tax Loss Harvesting means selling losing investments in order to register the Loss. The losses you register can be accumulated and carried forward, they are used to cancel out capital gains, or to reduce your ordinary income by $3000 per year. The order is Cap Gains must be canceled out first, then any overage can go onto OI, then any balance carried forward. A very powerful tool.

    The Wash Sale Rule (section 1091 IRS Code) was introduced to stop people selling a losing stock on Dec 31st, capturing the loss, and repurchasing on Jan 1st. They introduced a rule where if you purchase the replacement stock 30 days before or after you will trigger a wash sale. Wash sales disallow the loss, and instead the basis is recalculated. The verbiage is repurchase of the same or substantially identical security shortly before or after.

    The window of opportunity here is the phrase bolded - substantially identical. The 'same' is impossible to argue, if you sell Ford and then buy it again it is always going to be Ford. But when you buy Funds, what makes them identical? This is one of those grey areas where opportunity, and risk abound.

    The How


    The method I have been considering to address this started with 'pairing' funds. I am looking at correlation here. If we can find funds that are not substantially identical, yet move with correlation we have an opportunity to maintain portfolio balance while harvesting losses. I am still compiling the best pairings, but to give an example of how two substantially different funds perform, simply plug total stock market (VTI) and S&P 500 (VOO) into yahoo finance.

    vti voo.PNG

    This might be considered a clumsy pairing, or by the same token a safe one, as no financier would argue that these two funds are identical. As the nuances become narrower between the funds, so does the variance. The key is to find the closest correlation while maintaining quantifiable differences. A commonly discussed solution is to ensure that not only different firms are offering the fund, but more importantly that the funds are tracking different underlying benchmarks. Using Total Stock vs 500 is one such benchmark, but more subtle ones can occur using Russell Indices and others.

    The When

    This is the overplayed part. You can only Capital Loss Harvest when your investment is a loss. Sound simple? Well, more specifically, if your investment as appreciated and subsequently has depreciated, that doesn't necessarily create a harvest opportunity. This year (final week of July) we had a big drop in the S&P 500, 2.7% in 5 days. Despite this, only some people would have a capital loss harvest opportunity from this.

    If you had invested $10,000 in VOO on Jan 1st 2014 at the price of $167.73 it would have grown to a high of 182.15 per share in July, before dropping to $176.08. Despite this drop, you're investment is still up, as no realization event has occurred, and there is no Capital Loss Harvesting available to you.

    Conversely, if you had the misfortune to enter the market during July, and bought in at the high of $182.15 you would have the opportunity to harvest the loss when it had dropped down to $176.08. The window would be narrow, and within a month the asset would have regained its footing. An automated harvest here would offer a lot of value, if a person would exit VOO, lock in a loss of up to $333 in this transaction. The amount harvested is, of course, impossible to predict since it would require market timing and a crystal ball, but it would be possible to capture a maximum of $333 here.

    Moving the balance of $9667 into VTI for 1 month would have created a gain of 4.49% rather than 4.20% from VOO, as the total stock market performed better than the S&P500. After a month has passed, the VTI could be sold, and the portfolio could revert to VOO...

    Herein lies the problem of clumsy correlations. If the portfolio is put too far out of alignment by the replacement investment (VTI in this case) then the act of rebalancing it by selling out of VTI creates a capital gain event that nullifies the Capital Loss harvest. The key is finding the 'pairing' where you would be happy with either, and not need to rely upon it purely for a 30 day stop gap.

    Final Thoughts

    Pairing funds properly is the key to long term capital loss harvesting success, Any rebalancing that entails selling a winner (within a taxable account) destroys any effort to harvest losers. And as you can see, even with capital loss harvesting, timing is required both on entry to the trade, and when to lock in the loss, and as such can be overrated in a bull market.
     
    Last edited: Sep 16, 2014
  2. ElainePDX

    ElainePDX Level 2 Member Premium Supporter

    Great info. We have used losses to balance gains in the past, but did so when we wanted to get rid of something anyway. This is a good new way to think about it and I look forward to seeing the comments of others to add to the knowledge base. Thanks.
     
  3. Matt

    Matt Administrator Staff Member

    Whenever possible you shouldn't use them to balance gains. Gains are always taxed at a lower rate than income, so you are best to use them to reduce income for as long as you can.

    By which I mean, you should be strategic in when you sell and create gains.
     
  4. ElainePDX

    ElainePDX Level 2 Member Premium Supporter

    Yes, I get that. Not sure my post said it correctly. We don't sell specifically to balance gains but have used losses we've had that year or carried over from a past year to balance gains on CDs that matured, education bonds that matured, etc.
     
  5. Mountain Trader

    Mountain Trader Level 2 Member

    Matt-

    Very good post.

    Another angle to consider is doing the selling in a taxable account and the post-wash buying in a non-taxable account, such as an IRA. This is a very powerful tool if done right and done at the right time, and if the underlying assets just gets back to your original purchase point, you have tax losses from a breakeven investment.
     
  6. Matt

    Matt Administrator Staff Member

    Absolutely, I love the idea of taking losses on that side while protecting gains on the other.
     
  7. rhinodh

    rhinodh Level 2 Member

    By account, do you mean, for example, to sell in your Schwab taxable account and buy in your Fidelity IRA? Or could the accounts both be the same institution?

    The reason I ask is because I came across this at Schwab when reading more about Wash Sales:

    Link here.
     
    Last edited: Dec 12, 2014
  8. Matt

    Matt Administrator Staff Member

    I've not read your link.

    Wash sales apply to the security, not the account that you used to trade them.
     
  9. rhinodh

    rhinodh Level 2 Member

    Whoops. Copy/paste fail in my quote part from the link. I've corrected it.

    Basically it seems it's saying that if you do what @Mountain Trader stated above, Wash Sale still applies if both were Schwab accounts.
     
  10. Matt

    Matt Administrator Staff Member

    No- it has nothing to do with Schwab. It's not broker/account specific it is security transaction specific.

    If you do what @Mountain Trader proposes and do it wrong- you get a wash sale. It's a more advanced (but not that much of a leap) strategy.
     
  11. Matt

    Matt Administrator Staff Member

    Ps I'm on my phone replying from Madrid right now- else I'd go deeper- but if you want to lay out your understanding I would be happy to drill down when I get to a computer and am not running out to dinner :)
     
  12. rhinodh

    rhinodh Level 2 Member

    No worries!

    My understanding from @Mountain Trader's post was that you can sell in your taxable account and turn around and buy (within 30 days) in your non-taxable account without invoking the Wash Sale rule.

    But, from that Schwab article, it says doing just that (within 30 days) will invoke the Wash Sale rule.

    @Mountain Trader's post did mention "doing it right and done at the right time" so maybe that's the part I'm missing understanding on.

    I'm not trying to do this particular method in any of my accounts right now, just trying to learn something new (and still have lots to learn about investing in general).
     
  13. Mountain Trader

    Mountain Trader Level 2 Member

    My post spoke to Matt's strategy on harvesting tax losses. I did not try, nor did I, cover the entire subject of securities sales rules.

    It does not matter where the securities are held for measuring whether it is a wash sale. Buy in Schwab, sell in Fidelity or do it all at Schwab-it makes no difference in determining if it is or is not a wash sale.

    Good to see Rhinodh is reading up to understand the rules, and there are many others such as short/long term gains and losses, what is a capital asset, basis, etc.
     
  14. Matt

    Matt Administrator Staff Member

    Speaking of TLH Wealthfront just added Direct Indexing- this was an idea I had recently and posted about, though I doubt they stole it :)
     
    Last edited: Dec 12, 2014
  15. Matt

    Matt Administrator Staff Member

    Nope- the 30 days rule can't be avoided other than buying a not substantially similar security. Technically the time period is 61 days (30 before and 30 after)
     
  16. rhinodh

    rhinodh Level 2 Member

    Ahh, okay. That's the part I was misunderstanding. Thanks for the help!
     
  17. raenye

    raenye Lever 2 Membel

    I'm not sure I get the why. Is TLH just a method of deferring tax?

    Let's say that you bought stock A for $1,000 two years ago, and are selling it today for $1,500. A year ago it dipped to $800.
    Option one: no TLH. You earned $500 today and this is taxed.
    Option two: TLH after one year. Lost $200 last year (so tax benefit then) but earned $700 today (so increased tax now).

    :confused::confused::confused:
     
  18. Matt

    Matt Administrator Staff Member

    The key to the why is controlling your tax rate- capture losses and apply them to your ordinary income when earning at your salary peak = savings at your effective rate. Let's your winners run, and cash in when your rate drops (retirement/going back to school/etc)

    Your understanding is correct - just that when you 'pay tax later' it's at a different rate.
     
  19. Mike Tetlow

    Mike Tetlow Level 2 Member

    Just got an email from wealthfront .com saying they just turned on automated tax loss harvesting for all taxable accounts \o/ Previously it was just taxable accounts with a balance > 100k
     
  20. Barefootwoman

    Barefootwoman Level 2 Member

    My "stash" of carryover loss credits is getting low. (Losses were not accumulated through TLH, but through an employee stock plan from years ago). At the current income level and with few deductions, I'm getting slaughtered, so looking to make sure I can continue taking losses, if I can...as cleanly and painlessly as possible.

    I had an idea and would appreciate any feedback as to whether I'm off base or missing something.

    So, robo-advisors offer TLH services. I wouldn't be putting my entire portfolio under their management since a large portion is in tax deferred accounts and I'd obviously leave those where there are now.

    I was thinking about any benefits to putting my taxable account with a Robo-Advisor? I already have an asset allocation I'm comfortable with and there is no overlap between the type of funds held in my taxable accounts vs. my tax deferred accounts.

    Depending on whether the expense ratios are in line, might there be a benefit to transferring the account to a brokerage that offers TLH services? Would they receive funds in-kind and not force a change in the fund types to meet some kind of criteria that they recommend? (as opposed to letting me keep what I have)?

    Thoughts? crazy idea? other suggestions? I could do it myself I think, but doesn't that require almost daily eyeballs on the market?

    Appreciate any comments.
     
  21. Matt

    Matt Administrator Staff Member

    The robos will force you to use their own funds, so you'd have to sell. If you want to have a custom solution that allows you to access broader funds, and build around your existing ones you need something a bit more boutique. It does exist, and we offer it at my firm, as do certain other independent advisors.

    While it involves daily eyes, the Robo is limited to monthly transactions, since they only have one pair of ETFs as far as I recall, so you could keep up with it if you wanted to.

    Is it worth it? Difficult to say. In terms of price, it isn't much. If you look at 25bps for the service, a $100K account would cost $250 to manage. If you are in the 25% bracket then you'd need that service to harvest $1K per year to break even. There's some value not worrying about it too, so maybe if they only harvest $800 it's breakeven...
     
  22. traveler

    traveler Level 2 Member

    Tax gain harvesting is also a useful tool, especially for those who find themselves in the 15% FTB where LTGCs are taxed at 0%. I'm retired and in that bracket - I estimate my AGI and the sell shares of funds with LTGCs to the top of the 15% bracket. This resets the cost basis on those shares and because you're selling at a gain the wash sale rule doesn't apply - you can buy the same fund (stock) again immediately.
     

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